Financing and Valuation
• Student Presentations
• The After-Tax Weighted Average Cost of
Capital
• Valuing Businesses
• Using WACC in Practice
• Adjusted Present Value
Capital Project Adjustments
•
Adjust the Discount Rate
•
•
Modify the discount rate to reflect capital
structure, bankruptcy risk, and other factors.
Adjust the Present Value
•
Assume an all equity financed firm and then
make adjustments to value based on financing.
After Tax WACC
Tax Adjusted Formula
Given the following data:
Cost of debt = rD = 6%;
Cost of equity = rE = 12.1%;
Marginal tax rate = 35%;
Firm has 50% debt and 50% equity.
Calculate the after-tax weighted average cost of capital
(WACC):
A)
B)
C)
D)
7.1%
8.0%
9.05%
None of the above
After Tax WACC
Example - Sangria Corporation
The firm has a marginal tax rate of 35%. The cost of
equity is 12.4% and the pretax cost of debt is 6%.
Given the book and market value balance sheets,
what is the tax adjusted WACC?
After Tax WACC
Example - Sangria Corporation - continued
After Tax WACC
Example - Sangria Corporation - continued
Debt ratio = (D/V) = 500/1,250 = .4 or 40%
Equity ratio = (E/V) = 750/1,250 = .6 or 60%
After Tax WACC
Example - Sangria Corporation - continued
The company would like to invest in a perpetual
crushing machine with cash flows of $1.731
million per year pre-tax.
Given an initial investment of $12.5 million,
what is the value of the machine?
After Tax WACC
Example - Sangria Corporation - continued
The company would like to invest in a perpetual crushing machine with
cash flows of $1.731 million per year pre-tax. Given an initial investment
of $12.5 million, what is the value of the machine?
C1
NPV  C0 
rg
1.125
 12.5 
.09
0
Example - Sangria Corporation – continued
Perpetual Crusher project
expected equity income
Expected equity return  rE 
equity val ue
0.93

 .124 or 12.4%
7.5
Valuing a Business
Valuing a Business or Project
• The value of a business or Project is usually
computed as the discounted value of FCF out to a
valuation horizon (H).
• The valuation horizon is sometimes called the
terminal value.
PV 
FCF1
FCF2
FCFH
PVH


...


1  WACC (1  WACC ) 2
(1  WACC ) H (1  WACC ) H
Given the following data, calculate the value of the firm:
FCF1 = $7 million;
FCF2 = $45 million;
FCF3 = $55 million;
FCF grows at a rate of 4% for year 4 and beyond.
WACC = 10%,
A)
B)
C)
D)
$716.25 million
$801.12 million
$953.33 million
None of the above
Valuing a Business
Example: Rio Corporation
1
2
3
4
5
6
7
8
9
10
Sales
Cost of goods sold
EBITDA (1-2)
Depreciation
Profit before tax (EBIT) (3-4)
Tax
Profit after tax (5-6)
Investment in fixed assets
Investment in working capital
Free cash flow (7+4-8-9)
Latest year
0
83.6
63.1
20.5
3.3
17.2
6
11.2
11
1
2.5
PV Free cash flow, years 1-6
PV Horizon value
PV of company
20.3
67.6
87.9
1
89.5
66.2
23.3
9.9
13.4
4.7
8.7
14.6
0.5
3.5
2
95.8
71.3
24.4
10.6
13.8
4.8
9
15.5
0.8
3.2
Forecast
3
4
102.5
106.6
76.3
79.9
26.1
26.6
11.3
11.8
14.8
14.9
5.2
5.2
9.6
9.7
16.6
15
0.9
0.5
3.4
5.9
5
110.8
83.1
27.7
12.3
15.4
5.4
10
15.6
0.6
6.1
6
115.2
87
28.2
12.7
15.5
5.4
10.1
16.2
0.6
6
113.4 (Horizon value in year 6)
7
118.7
90.2
28.5
13.1
15.4
5.4
10
15.9
0.4
6.8
Valuing a Business
Example: Rio Corporation – continued - assumptions
Assumptions
Sales growth (percent)
6.7
75.5
13.3
79.2
5
Tax rate, percent
WACC
Long term growth forecast
35%
9%
3%
7
74
13
79
14
7
74.5
13
79
14
7
74.5
13
79
14
4
75
13
79
14
4
75
13
79
14
4
75.5
13
79
14
3
76
13
79
14
109.6
38.9
70.7
9.9
11.6
125.1
49.5
75.6
10.6
12.4
141.8
60.8
80.9
11.3
13.3
156.8
72.6
84.2
11.8
13.9
172.4
84.9
87.5
12.3
14.4
188.6
97.6
91
12.7
15
204.5
110.7
93.8
13.1
15.4
Fixed assets and working capital
Gross fixed assets
Less accumulated depreciation
Net fixed assets
Depreciation
Working capital
95
29
66
3.3
11.1
Valuing a Business
Example: Rio Corporation – continued
FCF = Profit after tax + depreciation + investment in fixed assets
+ investment in working capital
FCF = 8.7 + 9.9 – (109.6 - 95.0) – (11.6 - 11.1) = $3.5 million
Valuing a Business
Rio Corporation
FCFH 1
 6.8 
Horizon Value  PVH 

  113.3
WACC  g  .09  .03 
1
PV(horizon value) 
113.3  $67.6
6
1.09
WACC vs. Flow to Equity
– If you discount at WACC, cash flows have to be
projected just as you would for a capital
investment project. Do not deduct interest.
Calculate taxes as if the company were all-equity
financed. The value of interest tax shields is picked
up in the WACC formula.
WACC vs. Flow to Equity
– The company's cash flows will probably not be forecasted
to infinity. Financial managers usually forecast to a
medium-term horizon -- ten years, say -- and add a
terminal value to the cash flows in the horizon year. The
terminal value is the present value at the horizon of posthorizon flows. Estimating the terminal value requires
careful attention, because it often accounts for the
majority of the value of the company.
WACC vs. Flow to Equity
– Discounting at WACC values the assets and
operations of the company. If the object is to value
the company's equity, don't forget to subtract the
value of the company's outstanding debt.
Using WACC in Practice
• Multiple sources of financing
– Weighted average of each element
• Short term debt
– Generally can be ignored
• Other current liabilities
• Costs of financing
– Return on equity can be derived from market data
– Cost of debt is set by the market given the specific rating of a firm’s debt
– Preferred stock often has a preset dividend rate
WACC & Debt Ratios
Example continued: Sangria and the Perpetual Crusher
project at 20% D/V
Step 1 – r at current debt of 40%
r  .06(.4)  .124(.6)  .0984
Step 2 – D/V changes to 20%
rE  .0984  (.0984  .06)(. 25)  .108
Step 3 – New WACC
WACC  .06(1  .35)(. 2)  .108(.8)  .0942
Adjusted Present Value
APV = Base Case NPV
+ PV Impact
• Base Case = All equity finance firm NPV
• PV Impact = all costs/benefits directly
resulting from project
Adjusted Present Value
Example:
Project A has an NPV of $150,000. In order to
finance the project we must issue stock, with a
brokerage cost of $200,000.
Adjusted Present Value
Example:
Project A has an NPV of $150,000. In order to
finance the project we must issue stock, with a
brokerage cost of $200,000.
Project NPV =
150,000
Stock issue cost = -200,000
Adjusted NPV
- 50,000
Don’t do the project
Adjusted Present Value
Example:
Project B has a NPV of -$20,000. We can
issue debt at 8% to finance the project. The
new debt has a PV Tax Shield of $60,000.
Assume that Project B is your only option.
Adjusted Present Value
Example:
Project B has a NPV of -$20,000. We can issue debt
at 8% to finance the project. The new debt has a PV
Tax Shield of $60,000. Assume that Project B is your
only option.
Project NPV =
- 20,000
Stock issue cost = 60,000
Adjusted NPV
40,000
Do the project
Adjusted Present Value
Example – Rio Corporation APV
10 Free cash flow (7+4-8-9)
PV Free cash flow, years 1-6
Pv Horizon value
Base-case PV of company
Debt
PV Interest tax shields
APV
Tax rate, percent
Opportunity cost of capital
WACC (To discount horizon
value to year 6)
Lomg term growth forecast
Interest rate (years 1-6)
After tax debt service
Latest year
0
2.5
1
3.5
2
3.2
50
3.06
1.07
49
3
1.05
2.99
2.95
Forecast
3
3.4
4
5.9
5
6.1
6
6
48
2.94
1.03
47
2.88
1.01
46
2.82
0.99
45
2.76
0.97
2.91
2.87
2.83
2.79
19.7
64.6
84.3
51
5
89.3
35%
9.84%
9%
3%
6%
7
6.8
Adjusted Present Value
Example – Rio Corporation APV - continued
Next Class
• Tuesday, April 17
– Management Compensation – Chapter 12